March 29, 2023
How We Increased NOI by Over 50% Since 2021
Looking Beyond the Newspaper Headlines
Reading the newspaper headlines over the past year, you’d think the sky is falling for many commercial real estate investors. The headlines have been outright depressing… COVID lockdowns, extended eviction moratoriums, tenant protection ordinances, war in Europe, high inflation, interest rate hikes, tech job layoffs, bank failures, looming recession.
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Amidst all this uncertainty and media noise, our investors have been pleasantly surprised by the consistency, resiliency and strong performance of our Southern California apartment strategy. Indeed, despite COVID lockdowns, eviction moratoriums and other macroeconomic headwinds, the California rent-controlled properties we acquired in 2021 and 2022 have already seen…
…over 50% average growth in NOI since acquisition
Our investment approach – across all our strategies and markets – is very precise.
In short, we target property types that fill an essential need (e.g., affordable workforce housing) in supply-constrained markets with strong demand-side fundamentals and limited competition from institutional investors.
More specifically, in the U.S. we target rundown, poorly managed Class B and C apartment buildings with current rents 20-30% below market that can be acquired at large discounts to replacement cost (50% or more). We focus exclusively on stable working and middle-class neighborhoods across Southern California that are subject to statewide rent control (AB1482). We typically capitalize our investments with conservative amounts (around 50% LTV) of fixed rate debt.
Importantly, the properties we acquire provide an essential need – affordable workforce housing – to a large permanent renter class who comprise about two-thirds of all households in Greater Los Angeles. Our typical tenant is a “renter by necessity” who is priced out of homeownership due to the region’s costly and chronically supply-constrained housing market... and this was long before interest rates on home mortgages tripled over the past year.
As a result, our apartment properties tend to stay occupied, during good times and bad.
Indeed, historical occupancy levels at Class B and C apartment buildings in Los Angeles have consistently been in the 95-98% range over the past two decades, even during the heights of the 2008-09 Global Financial Crisis and 2020-21 COVID pandemic.
Dual Pricing Power that is Cycle Resilient
Targeting assets with a large “loss-to-lease” (current rents 20-30% below market) provides us a highly reliable stream of rental income to pay operating expenses and debt service, regardless of the economic climate. When market rents rise due to high inflation, as they’ve done in Los Angeles over the past two years, a high loss-to-lease on AB1482 properties gives us both the pricing power and ability us to capture much of that growth. More importantly, when economic winds shift and market rents decline by 10% or more during a recession, a high loss-to-lease means our cash flow will remain stable and potentially grow if any units become vacant.
Further, we always strive to set new rents at our properties that are relatively affordable and offer superior value to the working-class and middle-class households in the neighborhoods where we invest. The rents at our upgraded and repositioned Class B and C assets are typically about half the rents of newer Class A buildings. This provides us an additional competitive pricing advantage, insulating our investments from rent discounts and other concessions that Class A properties typically have to offer new tenants to maintain their occupancy levels during recessions. In short, Class A apartments buildings in Los Angeles cater to a completely different type of renter (“renters by choice”) than Class B and C properties (“renters by necessity”) and at a completely different price point in terms of rents (about a 50% differential). Indeed, it’s not uncommon to see some renters at Class A buildings move out and into more affordable Class B and C apartments during periods of economic uncertainty.
A Proven Formula for NOI Growth
So, the strong inception-to-date performance of our most recent investments is largely due to a combination of three factors…
- First is steady renter demand for the essential need that Class B and C apartments fill in Southern California, which in turn supports high occupancies regardless of economic conditions.
- Second is the dual pricing power of (i) a 20-30% loss-to-lease and (ii) 50% discount to Class A rents, which not only provides resilient rental income for Class B and C properties, but also allows experienced value-added investors like Paladin the opportunity to grow a property’s cash flow even during economic downturns.
- The third and most important factor is old-fashioned hard work. Superior returns never come easy, even for an experienced investor like Paladin (over the past three decades, we’ve made over 90 apartment investments totaling over 15,000 units). Ours has always been a management-intensive business, a simple reality that scares away many other large institutional investors. That’s one reason we like this space. It’s always nice to see the results of this hard work bear out profitably for our investors.
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